Wrong Notions About Interest

January 23, 1985|By Peter T. Maiken.

A college senior majoring in economics remarked the other day that his knowledge of basic theory had grown rusty. He had been so busy taking macroeconomics courses and working on complicated mathematical models that he felt he had to relearn the theoretical principles he had studied only briefly a few years earlier.

Such a pity, in this time of tax revision, to be without the guidance that basic economic theory could offer us, especially our lawmakers. The matter of interest, for instance, figures prominently in the tax revision plans, but there are few signs that one of the inequities of the present tax code will be any more than partially corrected. This is all the more regrettable because the provision in the code was probably based, from the start, on a misconception of what interest is.

Economic theory teaches us that interest ``earnings`` are earnings in name only. When one lends or borrows money, he enters into a simple transaction, exchanging things of equal value. A borrower, with his promise to repay a loan, exchanges future for present dollars. A lender does the opposite. The borrower chooses to be an immediate consumer; the lender chooses to defer his consumption. Nonetheless, they are exchanging equivalents.

Because future dollars are not worth as much as present ones, their value is discounted. This is true for the same reason that, to a hungry person, a meal now is worth more than the promise of one at some future time.

The percentage by which future dollars are discounted, economic theory tells us, corresponds to the rate of interest. It has nothing to do with risk or inflation. (Both figure into the rate of ``interest`` one pays on a loan, but they are in fact administrative charges determined by the degree of risk and the rate of inflation involved and are added to the actual interest itself.)

The basic rate of interest is a function of the passage of time, and it is an expression of the fact that immediate utility is worth more than future usefulness.

Now, if a lender is merely exchanging present dollars for future dollars, with both amounts equal in value, how can it be said that he is ``earning``

anything? In the economic sense, he is not. The term is purely of political convenience.

Historically, lenders have been perceived as well-to-do people, and soaking the rich is not politically unpopular. Borrowers are commonly thought to be needier. Therefore, a tax code that discriminates against lenders and favors borrowers, as our does, results from fully predictable public policy. Of course, many of us are both lenders and borrowers in varying degrees, so it is not an issue of rich versus poor. The discrimination, nonetheless, is still there.

For example, if you are a wage-earner who saves a portion of your income, you will be taxed on the interest you ``earn,`` even though you are netting no real gain and simply deferring consumption.

If you have borrowed money to buy a house--because you want to use the house now rather than later--you have the privilege of deducting the interest you pay on the loan from your taxable income.

As a result, those who put something away for the future are penalized, while those who go in debt to spend now are rewarded.

Under the proposed tax law changes, one could no longer deduct interest payments on second-home mortgages. Apparently there is widespread agreement that people in this presumably well-to-do circle do not deserve such subsidized tax savings.

There seems to be little similar sentiment, however, that those borrowing to pay for their primary dwellings should lose their favored status. Any attempt to eliminate their interest deductions would meet the wrath of real estate interests, the building trades, the lending institutions, and virtually anyone who thinks of home ownership as the fulfillment of the American Dream. (Never mind that building second homes also creates jobs and stimulates the economy--logical consistency doesn`t come into play here.)

Thus we will probably continue to live with this double standard in our tax code, and non-homeowning taxpayers will continue to subsidize the tax bills of the relatively smaller though more affluent group of citizens who have sizable mortgages.

A lawmaker seeking to change the present rules would face political oblivion. And if he voted to drop the tax on interest ``earnings,`` he would be denying himself revenue with which to carry out his programs or balance the budget. So in the end, politics will surely triumph over economic logic.

The rate of interest, theory tells us, is the means by which any economy

--capitalistic or otherwise--allocates its wealth between present and future consumption. Whenever political actions are aimed at altering this balance, they invariably distort the allocation and the economy itself. Whenever the saver is penalized, the real losers are those who will inhabit the future.

Reforming the tax code so that interest is neither tax deductible as an expense nor accountable as income would not destroy the dream of home ownership. People would continue to buy homes, but their purchase would no longer be subsidized and their decision would be influenced by market conditions rather than governmental discrimination.

On the other hand, if we think that future generations should subsidize present ones, then we should leave the tax code`s treatment of interest just the way it is. Many observers, however, think that we have already mortgaged our children`s future to too great an extent.

Because a lot of the pro-debtor arguments stem from a fundamental misconception, it`s too bad that both lawmakers and college students are allowed to forget what interest is all about.